Monday, September 15, 2008

Shadow Banking and You

Friends and relatives have been calling and emailing us today to ask if their personal bank accounts are safe. The short answer is -- probably. It depends on the totals and how you have structured the ownership of each account.

We noted this once before and linked to the FDIC on-line calculator, right here.

From the point of view of individual consumers who have personal or business bank accounts, it's the availability of FDIC insurance and regulatory oversight that are two of the more important distinctions between commercial banks and what has come to be known as the "shadow banking system" of investment banks like Bears Sterns and Lehman Brothers. From a consumer viewpoint, insurance and regulatory oversight limit the consequences of this latest Wall Street crisis. From the viewpoint of Wall Street's shadow banks, it was the absence of regulation that contributed to their undoing.

Those who were complaining, only months ago, that excessive regulation was making American markets uncompetitive, had it exactly wrong. It was a lack of regulation of the shadow financial system and its players that allowed this to happen. The regulators might not have gotten it right if they had tried to put limits on leverage, or assure that it was clear what risks were being taken, in the world of derivatives and securitizations. But deciding not to even try, and assuming that risks traded secretly would somehow end up in the hands of those most able to bear them, reflected ideology, not analysis.

The failure of shadow banks, it needs to be said, can ultimately shake commercial banks, too, and even lead to their demise. Indeed, that is why many were alarmed last week when it became known, as reported in Insurance Daily, that Berkshire Hathaway "stopped selling private bank deposit insurance above the amount guaranteed by the U. S. government."

Does Warren Buffett foresee the current financial crisis spilling over into what some misleadingly call the "real economy?" Only he knows for sure. But it's worth recalling that in his 2002 Letter to Shareholders of Berkshire Hathaway, Buffett presciently predicted the current crisis in the "shadow banking" system. He also observed at the time that "real economy" companies and banks are linked to shadow banks "in ways that could cause them to contemporaneously run into a problem because of a single event."

One hopes Mr. Buffett is wrong. But it would be foolish to bet against the richest man in the world.